Smart tax strategies for Business Succession Planning
If you are an owner or owner/manager of a privately -owned business, you already know that you face formidable challenges. Creating an effective succession/exit arrangement and estate plan are just two of them. As a business owner you might have been avoiding succession planning due to a variety of reasons :
• Subconsciously wanting to skirt thinking about the fact that you won’t be running the business forever which brings you income, social contacts, and purpose to your life.
• Need “buy in” from all parties. For family-owned or controlled businesses, succession planning usually touches deeply emotional personal issues.When you avoid talking about your family differences, you magnify the problem which you are trying to prevent (Hubler’s Speck of Dust Theory).
• Being too caught up in present-day business issues and not knowing where to begin, as business succession planning is a long term(3-5 years) complex process.
Businesses working without a succession plan can invite disruption, uncertainty, conflict, and endanger future competitiveness.
“ The final test of greatness in a CEO is how well he chooses a successor and whether he can step aside and let his successor run the company.” -Peter Drucker
Succession Planning : Family Members
If you decide that the family succession is the best option for your business, consider the timing carefully. A solid succession plan can fail just because the timing of the transition period is wrong( the timing can be flexibly managed by use of family trust-discussed later in this article).
If you bring the children into the business too early, they may lack the broader work experience that many business owners bring into their business when they start the enterprise.
This might make you reluctant to place your children in a position of responsibility, leading to slower development and possible job frustration.
In contrast ,if you delay the entry into the business too long, you run the risk of your children seeking and developing another career opportunity that they don’t want to leave.
While the right time to make the transition will vary by business, try to ensure that the end of your children’s learning curve coincides more or less with your ultimate departure from the company.
The dilemma you may be facing is whether to “bite the bullet” now and pay the capital gains tax based on today’s fair market value, or leave things as they are and have your estate bear the capital gains tax burden at the time of your death, based on that fair market value. For some visual context watch Mikes Story.
When it comes to tax planning, a good principle to follow is that you should never trigger a tax liability any sooner than you have to. This article discusses important tax strategies to defer the taxes on change in business ownership as a part of a succession plan.
2019 BC personal/corporate investment tax rates
Estate Freeze :
An estate freeze supports the future growth in the business to accrue to the next generation, thereby locking the growth on which current owners will be taxed on death.
Consider carrying out an estate freeze if you own your business.
In our opinion, generally, it is worthwhile to do an estate freeze if your overall net worth is more than $10 million. This is a “rich man’s game”.
The most common objective of an estate freeze is to freeze the value of assets owned by a wealthy taxpayer (often shares of an operating company) at their current fair value and pass future increases in the value of the assets on to younger family members.
Holdco Freeze under section 85
Let us say; you want to pass future growth of your company to your daughter while providing for your retirement.
You can form a holding company and have your daughter subscribe for common shares at a nominal amount. Transfer shares of the operating company to the holding company under the provisions of Section 85 in exchange for non-share consideration and Holdco preferred shares.
Ensure non-share consideration is not more than the greater of the modified Adjusted Cost Base(ACB) and the Paid Up Capital of the operating company shares to avoid a Section 84.1 deemed dividend.
If you wish to crystallise the capital gain, elect a transfer price equal to the ACB of the operating company shares plus your remaining Lifetime Capital Gain Exemption(LCGE) available. Determine whether the preferred shares should be voting or non-voting, based upon your desired level of involvement in the business.
Beware of new Passive Income Rules :Small Business Deduction Grind
Any dividend transfer from an operating company to holding company is tax-free, a part of these dividends can be distributed to you to augment your retirement income. Let us say holding company receives $200,000 /year as dividends, and declares $100,000/year dividends to you as your annual retirement income.
The holding company stockpiles excess cash over the years to acquire investments such as real estate or a portfolio of securities. Let us assume that the passive income earned from these investments is $100,000.
Beware that the new passive income rules (2018) are intended to encourage business owners to spend more time expanding the active portions of their businesses rather than directly buying up a lot of passive investments and letting that income accumulate.
The amount eligible for the small business rate shrinks by $5 for every $1 over $50,000 that a business makes in passive income until it eventually reaches zero. Since Holdco and Opco are associated, the investment income rules will reduce the small business limit of Opco, costing Opco an additional $37,500 of tax for the year, and a similar amount every year if Holdco maintains equal levels of investment income.
Internal Freeze -Section 85
The difference between an internal Section 85 freeze and a Section 85 Holdco freeze is that with an internal freeze, the shareholders directly own the shares of the first corporation instead of indirectly owning the shares through a holding company.
Internal Freeze-Section 86
As an alternative to section 85, an internal freeze could also be undertaken using a share exchange under ITA subsection 86(1), but that would not allow you to crystallise your Life Time Capital Gain Exemption (LCGE).
It would allow you to freeze the value of your company in the newly issued preferred shares so that your family member could also become a shareholder(by subscribing for common shares for a nominal amount) and receive dividends.
The advantage of the ITA subsection 86(1) rollover is that it is automatic and there is no election form to file. You would exchange your current shares in your company for newly issued preferred shares (“frozen shares”) of your own company.
The preferred shares you would receive would have the same Adjusted Cost Base/Paid Up Capital as the shares given up. The freeze also creates an opportunity for you to utilise an additional LCGE, which may be very important if your company shares are sold in the future.
If the business grows and becomes more valuable, the increase in value may be sheltered from tax because your family member would also have an LCGE to utilise, assuming the family member has no tax balances that may impact the LCGE (e.g., CNIL).
Alternatively, a family trust could be set up as part of an estate freeze to subscribe for common shares. The use of a family trust can allow flexibility about the timing and amount of distributions to the beneficiaries and provide for control and management by the trustees, including until a time that the children or other intended beneficiaries are financially mature.
“ There is nothing like staying at home for real comfort.”-Jane Austen
Before undertaking an estate freeze, you need to be confident there are sufficient assets and income available to maintain their desired lifestyle until death. Your CPA and lawyer must be consulted, as this is a complex succession-planning technique.
If the estate freeze is structured correctly, you may be able to maintain control, if desired and take advantage of the capital gains exemption for qualified small business shares. It may also be possible to multiply the use of the capital gains exemption with family members.
Before Tax on Split Income (TOSI) rules
• Using family trust to income split with spouses and adult children was very common.
With New Tosi Rules
• Limited ability to income split.
• New reporting requirements will require disclosure of trust to beneficiaries.
For more information on TOSI rules –Ways to avoid tax on split income(tosi)
Succession Planning: Sale to an outsider
Source : BDC Survey
Latest statistics also reveal that there is a low survival rate of family-owned businesses when ownership has passed from one generation to other.
A common reason is that none of the children have any interest in working in the company as they want to pursue their own goals, rather than “following the Daddy’s footsteps”. In the real world of “Family Business”, it often makes more sense to find an outside buyer, or to have current owner/manager adopt an exit strategy that does not involve a family succession arrangement.
“If this transition is not managed well, the family has a higher risk of losing its wealth through bad investment decisions and over-consumption” – John Davis
In this situation, if you want to help your children, you may be better off selling your business to a qualified third party and allow your children to enjoy the proceeds when they’re passed down to them.
Step one would be to understand the factors and issues that go into valuing your business. This can help maximise its value for a sale or the estate.
If you are the primary asset of the company, the business would likely have a higher sale value if you can help a new owner get established (maybe through a management contract).
You will need to decide on the sale of shares vs sale of assets, and usually, the sale of shares is a preferred choice. However, the purchase of assets is generally the popular strategy for the buyers. For more information on understanding the position of the buyer, please read Planning on buying a business.
Conclusion: Tax planning is often overlooked when there is no succession plan. You owe it to yourself and your family to arrange your financial affairs in such a way that income taxes (including taxes on capital gains ) arising in your estate are minimised or postponed as much as possible – provided of course that you do “not cross the line ” into the realm of improper tax evasion.
You should talk to your CPA and lawyer who can advise you on the appropriate strategy which can help you maximise the benefits of your succession plan, treat your employees fairly; and minimise any taxes that might be due.
CIBC. “Estate Planning Strategies for Small Business Owners.” Www.cibcwg.com, 2011
“How to Ride the Coming Wave of Business Sales.” BDC, www.bdc.ca/en/articles-tools/start-buy-business/buy-business/pages/buying-business-how-take-advantage-coming-wave-entrepreneur-retirements.aspx.
Jeffs, Dallas. “Understanding the New Federal Passive Income Rules for Small Businesses.” QuickBooks, QuickBooks, 14 May 2018, quickbooks.intuit.com/ca/resources/pro-taxes/federal-passive-income-rules-small-businesses/.
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